Managing Clients' Loss Aversion

This month's article is the second in a series called "Managing Behavior in a Volatile Market." The new series will provide data and insight into not only identification of key behavioral biases that your clients are likely to exhibit but also how to manage this behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

The survey questions were written to identify 20 key behavioral biases that I outline in my book Behavioral Finance and Wealth Management. The intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases") so advisors would know what to look for when working with their clients. Secondly, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents needed to answer at least "Agree" or "Strongly Agree" to a question designed to identify a given bias. There were seven biases that garnered at least 50% positive responses; these were the following:

Loss Aversion Bias: the pain of losses is greater than the pleasure of gains

Anchoring Bias: getting "anchored" to a price point when making an investment decision

Hindsight Bias: believing that investment outcomes should have been predictable

Recency Bias: Taking investment action based on the most recent data or trend rather than putting the current situation into historical perspective

Representativeness Bias: Making current investment decisions based on how past similar investment decisions turned out

So when you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be some of the most commonly encountered.

So let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to?

Fifty-eight percent of 178 people who responded agreed or strongly agreed to a question asking them if they were subject to loss aversion (i.e., if the pain of losses is at least two times the pleasure of gains). Of that group, at least half of those people were also subject to the following six biases:

For example, of the respondents that said they were loss averse, 67% were also subject to a question designed to identify anchoring bias, and so on for the other five biases.

In this article, I will provide commentary on the first three of these biases, anchoring, regret, and representativeness. I will discuss why these biases are likely linked with loss aversion and what one can do to counsel a client with these biases. Next month in Part II, I will discuss hindsight, availability, and status quo.

Loss Aversion and AnchoringLoss aversion and anchoring are naturally tied. It should make sense that if one feels the pain of losses, they are doing so in reference to a starting point. For example, if Jim buys a stock fund at $100 and it goes down to $80, he is not going to be happy. He is likely to get "anchored" to the $100 purchase price because that is the point at which he will "break even" and stop the pain associated with losses.

Further suppose this stock fund was purchased in a highly overvalued asset class (Jim did not do enough research before he bought it). Even with the loss, the asset class is still overvalued. The prospects for the fund are not so good. What will Jim do?

Paradoxically, many investors accept more risk to avoid losses than to achieve gains. Loss aversion may lead Jim to hold this loser even if the investment has little or no chance of going back up anytime soon. Similarly, loss-aversion bias leads to risk avoidance when people evaluate a potential gain. Given the possibility of giving back gains already realized, investors often lock in profits, thus limiting their upside.

Advice: Because loss aversion is an emotional response to losing money, it is often difficult to correct. Anchoring is a bit easier to correct for in that a reference point can easily be identified. What I recommend is that advisors focus their clients' attention not on the purchase price but rather the prospect of a positive result from the current price. Would you make the investment now? If the answer is yes, then holding is the right course of action. If the answer is no, the right course of action is to sell.

Loss Aversion and RegretLoss aversion and regret are also naturally tied. It make sense that if one experiences a painful loss, future investing behavior would be affected. Regret-aversion bias is an emotional bias in which people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. Simply put, people try to avoid the pain of regret associated with past bad decisions. Regret aversion can keep some investors out of a market that has recently generated sharp losses or sharp gains. Having experienced losses, our instincts tell us that to continue investing is not prudent. Yet periods of depressed prices may present great buying opportunities. Regret aversion can persuade us to stay out of the stock market just when the time is right for investing. On the upside, fear of getting in at the high can restrict new investments from taking place.

Advice: My advice to advisors is to counsel your clients that they will make investment mistakes. Everyone does (even you!). The best investors in the world make meaningful mistakes. In today's market environment of extreme volatility, many advisors are seeing their clients frozen in place when trying to take action because they don't want to see a new investment get driven down immediately. What I recommend is for clients to "average in" to the markets-- taking three months or six months to get fully invested. This often puts the fear of losses aside; if an investment goes down, you can buy more at lower prices.

Loss Aversion and Representativeness BiasLoss aversion and representativeness are also quite related. At its core, representativeness bias is the idea that some investors tend to use prior experience as a frame of reference for current decisions. (Technically speaking, representativeness bias is a belief-perseverance bias in which people, when confronted with new information, use pre-existing beliefs to help classify the information, even if the new information does not necessarily fit an existing belief.)

For example, similar to regret, if we lost money on "technology stocks" at some point in the past, every time we are presented with anything that resembles technology stocks, we may view it through the lens of a prior loss experience rather than objectively assessing positives and negatives of a new investment idea.

Advice: Advisors need to encourage their clients to judge every investment idea on its current merits, not based on past experiences. Investment ideas and asset classes go through cycles of attractiveness and unattractiveness. Be flexible in your thinking! And, most importantly, pay attention to valuation.

ConclusionWhen you encounter a client with loss aversion, hopefully you can now be aware and plan for some of the other biases connected with it. It might help to build a better client relationship! In next month's article, we will review Part II of the biases associated with Loss Aversion. Thanks for reading!

Michael M. Pompian, CFA, CFP is an investment consultant to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.